Investment strategy

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Key points:

  • We downgrade modestly our US growth forecast to 2.2% in 2019 and still do not see a recession over the next 12 months
  • We also reduce our Eurozone growth forecast to 1.2% in 2019, with a challenging external backdrop (read China slowdown) risking to spill over to domestic demand
  • The impact of the Chinese fiscal and monetary stimulus therefore becomes of paramount importance
  • We maintain our limited risk appetite, upgrade Euro IG credit to neutral and emerging debt to overweight

Read the full executive summary 

Executive Summary

Keep Calm: the US should dodge a recession in the next 12 months

Mindful of the sharp tightening of financial conditions since the publication of our 2019 Outlook1 , we have updated our probabilistic model of US recessions. Clearly, our outlook for the US economy, which was below consensus back in November, was a herald of subsequent market fears. Since the relationship between the recession risk and the market sell-off goes both ways (with our assessment of a causal, rather than casual, link between the UST yield curve inversion and economic recessions2 ), the question was whether market events had overtaken the economic outlook and threatened an even sharper slowdown in activity3 .

Good news: while we estimate that the probability of recession has been rising, it remains below critical thresholds, confirming our assessment that we are moving closer to the end of the cycle. However, our models are not signalling a sharp downturn in the next twelve months. That said, we do expect banks to tighten their lending conditions for households, small and large firms, which we see as the key driver of the US economic slowdown this year and next. As a result, we have revised our outlook for US GDP growth slightly lower to 2.2% for 2019 (from 2.3%). This is even further below the 2.5% consensus, but still, we argue, above the US potential growth rate. Interestingly, the transmission of this deterioration, from financial conditions to the real economy through the banking system and broader credit conditions, will take a substantial period (several quarters and up to a full year) before it is reflected in the most surveyed economic and market variables. Even a forward-looking indicator like the ISM business survey has historically lagged our recession model by around six months.

Our analyses and forecasts indicate that this reassuring message from the US economy can be extended globally. First, the Eurozone has been slowing dramatically since early 2018 and we expect Italy to fall back into technical recession, while Germany looks set to only narrowly avoid one. But the magnitude of the recent macroeconomic disappointment has been exacerbated by a collection of one-offs: changes to German auto emission standards, Italian budget concerns, the French gilet jaunes disruption… We do expect a modest, upward normalisation in sequential growth ahead. Second, the monthly dataflow from China has been worryingly soft, with trade, for example, free-falling. Here again, we expect data to get worse before they turn better… but the Chinese authorities have already begun to deploy the available arsenal of stimulatory measures, including some monetary easing and a greater boost from fiscal policy, which already appears to have arrested the sharp deceleration in infrastructure spending, but will likely take longer (we estimate until at least the second quarter) to show more obvious signs of traction in the broader economy. “Stability” was a clear key word at the Central Economic Work Conference held at the end of December and we expect Chinese authorities to monitor activity closely to achieve this end. Altogether, we have edged our growth forecasts only slightly lower for the US (2.2%), Eurozone (1.2%) and China (6.1%) for this year. However, we note other forecasters, including the latest International Monetary Fund global forecasts, are moving more quickly towards our view.

But please don’t Carry On with political procrastination

And still, the combination of a challenging market and macro environment (the ebbing of the tide of global liquidity as the cyclical expansion likely nears its end) with a high level of political procrastination leaves us with an unsettling feeling of déja vu. For example, signs of progress and encouraging high-level meetings have created hopes of an appeasement in the US-China trade war. Still, if no proactive decision is made, the 10% tariffs on 250bnUS$-worth of US imports from China will almost automatically turn into a more harmful 25% on 1 March. The extreme polarisation of US politics has also lead to the longest, and still ongoing, partial government shutdown in US history. True, the economic impact remains muted (we estimate it will have an annualised impact of about 0.2pp in the first quarter to date) as 75% of government is still funded. But this only serves to allow the shutdown to continue for longer! But the most emblematic example comes from the UK where the Brexit process seems trapped in version of the film Groundhog Day starring an intransigent UK Prime Minister Theresa May instead of (a young) Bill Murray. Worried that a December Parliamentary vote on the 558-page Withdrawal Agreement (also known as “the deal”) would see a heavy defeat, May postponed the vote to January in the hope of rallying extra support for it. Despite the additional time, she lost by an unprecedented margin of 230 votes. With a Parliamentary amendment forcing the government to suggest a plan B only three days later and with Labour leader Jeremy Corbyn refusing to engage in cross-party discussions, the UK Parliament could end up voting on what is effectively the same deal - as if the previous vote and subsequent vote of no-confidence had not taken place!

Interestingly, most political analysts and economists we met to hopefully challenge our view (including the impressive Lord William Hague) agreed with our judgement that the probability of the most adverse outcome occurring (id est exit without any deal on 29 March) was somewhere between 10 and 20%, with our estimate towards the higher end of this interval. Yet here again, if no proactive decision is made, a no deal Brexit is the default option, the highly disruptive consequences of which cannot be robustly estimated as no prior event even vaguely resembles such an outcome.

Asset allocation: positive but limited risk appetite, back to neutral on Euro IG credit

In this context, we maintain our reduced risk appetite but still remain overweight equities in the US and emerging markets. Valuations are no longer a headwind in the former and even a potential (medium-term) tailwind for the latter. More importantly, our carefully constructive macro outlook is consistent with modestly positive returns backed by earnings and despite our expectations of further de-rating in the price/earnings ratio. The main change this month comes from bringing our exposure to Euro IG credit back to neutral with the past spread widening offering more reasonable valuations. We also upgrade emerging debt to overweight on the back of a more dovish Fed, less pressure from the US dollar and, here also, cheap valuations.

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